Sixth Circuit Panel Finds IRS Cannot Use Substance Over Form to Recharacterize DISC-Roth IRA Structure

A Sixth Circuit panel in the case of Summa Holdings Inc. v. Commissioner, No. 16-1712, CA6 reversed the Tax Court in case involving transactions involving a Domestic International Sales Corporation (DISC) and a Roth IRA should be recharacterized as being a method of making impermissibly large contributions to the Roth IRA. 

The case concludes by noting:

The last thing the federal courts should be doing is rewarding Congress’s creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.

The panel specifically was highly skeptical generally of the use of the substance over form doctrine to address what might appear to be unintended consequences of Congressional action.

The third paragraph of the opinion makes this clear, stating:

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

The panel immediately goes on to hold that neither the IRS nor the courts have such authority.  Rather, the opinion holds that if the result is not what Congress intended (which, the panel concedes, may very well be the case) it is up to Congress to remedy the matter.

The panel first explains the basics of a DISC:

Congress designed DISCs to incentivize companies to export their goods by deferring and lowering their taxes on export income. Here’s how the tax incentives work. The exporter avoids corporate income tax by paying the DISC “commissions” of up to 4% of gross receipts or 50% of net income from qualified exports. The DISC pays no tax on its commission income (up to $10,000,000), 26 U.S.C. §§ 991, 995(b)(1)(E), and may hold onto the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability, id. § 995(f). Once the DISC has assets at its disposal, it can invest them, including through low-interest loans to the export company. See 26 C.F.R. § 1.993-4. Money and other assets in the DISC may exit the company as dividends to shareholders.

The dividends are not protected from tax, but it does eliminate the double taxation of such income that otherwise would arise in this setting.

It did not take long for individuals to notice that if a tax-exempt entity held the shares that the dividends would not be subject to a tax.  If a regular IRA held the DISC there would eventually be a tax paid when the beneficiary took a distribution, but that date could be very far in the future.

But in 1989 Congress plugged that hole by enacting IRC §995(g) which required tax-exempt entities to pay an unrelated business income tax on such dividends, which is imposed at the corporate tax rate.  A traditional IRA no longer looked nearly as appealing as the holder of DISC shares since it would pay a tax internally, and then the beneficiary would later pay tax yet again on the funds when a distribution was taken.

However, eight years later (in 1997) Congress created a new form of IRA (the Roth IRA) where the tax on the distribution to a beneficiary would no longer apply if certain requirements were met.  Now the math again began to look promising if a Roth IRA (rather than a traditional IRA) holds the shares.

As the panel continues:

At this point, one can begin to see why the owner of a Roth IRA might add shares of a DISC to his account. The owner of a closely held export company could transfer money from the company to the DISC, as the statute encourages, and pay some (or all) of that money as a dividend to its shareholders, allowing the money to enter the Roth IRA and grow there. The IRA account holder, it is true, would have to pay the high unrelated business income tax—here roughly 33%—when the DISC dividends go into the IRA. But once the Roth IRA receives the money, the account holder could invest it freely without having to pay capital gains taxes on increases in the value of each share or incomes taxes on the dividends received—just like other Roth IRA owners who buy shares of stock in companies that generate considerable dividends and rapid growth in share value. As with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the account after he hits the requisite retirement age.

Given that contributions to Roth IRAs are capped (the amount was $5,000 in 2008, the year in dispute) and once an individual’s income exceeds certain levels eliminated, the DISC appears to offer an option to push a much larger amount of funds into the Roth IRA by paying commissions to a DISC owned by Roth IRA, which then can pay out dividends which the Roth IRA can then invest as it wishes.

The IRS, though, argues that this result is not what Congress intended and claims that it should be able to restructure the transaction based on “substance over form” in this case.  That is true even though the IRS agrees that DISCs were designed by Congress to receive tax free commissions from related organizations and Roth IRA were designed to provide tax free income streams to their beneficiaries.

As the panel outlined the IRS’s view:

That leaves the Commissioner to invoke another, distinct version of the substance-over-form doctrine. When two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, the Commissioner claims the power to recharacterize the transactions as the higher-taxed equivalents. It’s not that the transactions don’t have economic substance (they do) or that the Code forbids them (it doesn’t). Instead, the Commissioner simply stipulates that the “real” transaction is the higher-taxed one, and that the lower-taxed route, often the more complex of the two, is a mere “formality” he can freely disregard. The Commissioner claims the right to assert this power against “any given transaction[,] based on [the] facts and circumstances” of the arrangement. Appellee’s Br. 63. That is a much broader (and more worrisome) version of the doctrine.

The panel does go on to note that some support for this idea can be read into Justice Black’s opinion in the 1945 case of Commissioner v. Court Holding Co., and even that some cases emanating from the Sixth Circuit have suggested that Court Holding should be read broadly to allow such recasting of transactions.

But the panel takes the position that the substance over form doctrine should not apply if the only objection is that it saves taxes.  As the panel states:

The substance-over-form doctrine, it seems to us, makes sense only when it holds true to its roots—when the taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process. But who is to say that a low-tax means of achieving a legitimate business end is any less “substantive” than the higher-taxed alternative? There is no “patriotic duty to increase one’s taxes,” as Judge Learned Hand memorably told us in the case that gave rise to the economic-substance doctrine. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934). “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury.” Id. If the Code authorizes the “formal” transactions the taxpayer entered into, then “it is of no consequence that it was all an elaborate scheme to get rid of income taxes.” Id.; see also David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax Law. 235, 236-41 (1999).

The Court goes on to find that this transaction fails to be one where the IRS has the right to restructure the transaction:

The Commissioner’s effort to reclassify Summa Holding’s transactions as dividends followed by Roth IRA contributions does not capture economic reality any better than describing them as DISC commissions followed by dividends to the DISC’s shareholders. In what way is this “substantively” a contribution? Sure, the transaction in one sense looks like a Roth IRA contribution given the flow of money through the DISC and into the IRAs. But on balance the transaction looks even more like what it was—DISC commissions followed by dividends to the Roth IRAs. This is not a case where the taxpayers followed a “devious path” to a certain result in order to avoid the tax consequences of the “straight path,” as in Kluener and Aeroquip-Vickers. See Minn. Tea Co., 302 U.S. at 613. Both paths involve two straightforward steps: a disbursement from Summa Holdings (to either the DISC or the Benensons) followed by a transfer to the Roth IRAs (either as a dividend or a contribution).

The Court also indicates that it’s irrelevant that the parties intended this structure to work around the contribution limits, stating:

When the Commissioner says that the transaction amounted in substance to a Roth IRA contribution, all he means is that the purpose of the transaction was to funnel money into the Roth IRAs without triggering the contribution limits. True enough. But the substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.

The panel then goes on to hold that if this result is not what Congress intended, Congress needs to fix it:

If Congress sees DISC-Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the DISC will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended -- even if subsequent changes to the Code have increased the scale of the savings beyond Congress's original estimation.